Valuation Discounts and the Step Transaction

            Recently there have been a number of cases dealing with the step transaction doctrine in the IRS’s attempt to disregard valuation discounts for gift tax purposes. This doctrine “collapses ‘formally distinct steps in an integrated transaction’ in order to assess federal tax liability on the basis of a ‘realistic view of the entire transaction.’” Heckerman v. U.S., 2009 U.S. Dist. LEXIS 65746, *32 (W.D. Wash., July 27, 2009) (citations omitted). As is often the case, the decisions do not provide the magical timeframe between the funding of an asset to an LLC or partnership and the gifting of the business interest, but they do reveal the importance of structuring the transaction so that the taxpayer is exposed to “real economic risk” during the period between funding and gifting.
            Just recently, in Heckerman, the court reiterated two important takeaways. First, the court reasoned that simultaneous funding and gifting is clear proof of an integrated transaction and will result in the application of the step transaction doctrine. Second, and more importantly, the court recognized that the volatility of the asset is material to the analysis of whether enough time lapsed between the funding and the gifting. Accordingly, the taxpayer must show that he “bore. . . real economic risk that the LLC units would change in value between any alleged time intervening between the funding and the gifting, given the nature of the assets transferred to [the]. . . LLC.” Heckerman, 2009 U.S. Dist. LEXIS 65746, *40. Given that the underlying asset in Heckerman was cash, the taxpayer was unable to prove that the alleged few week delay caused a “real economic risk.” A similar position was taken in the case of Linton v. U.S., 2009 U.S. Dist. LEXIS 56604 (W.D. Wash., July 1, 2009), decided just a few weeks prior to Heckerman. In Linton, there was no concrete evidence that the funding and gifting did not occur on the same day. Nevertheless, the taxpayer argued that a period of nine days passed between the funding and gifting. The court held in favor of the government because the assets at issue (cash, municipal bonds and real estate) were deemed not sufficiently volatile such that the taxpayer would have bore any material economic risk over the alleged nine-day period. Linton, 2009 U.S. Dist. LEXIS 56604, *36.
            In contrast to Heckerman and Linton, in Gross v. Comm’r, T.C. Memo 2008-221, 2008 Tax Ct. Memo LEXIS 218, 96 T.C.M. (CCH) 187 (2008) and Holman v. Comm’r, 130 T.C. 170, 2008 U.S. Tax Ct. LEXIS 12 (2008), the taxpayers’ delay between the funding and gifting was sufficient to combat step transaction treatment, given the particular assets at issue. Both cases dealt with marketable securities and the taxpayers avoided the step transaction by separating the funding and the gifting by a period of 6 days in Holman and 11 days in Gross
These cases show that the trend in analyzing whether a step transaction exists is to determine whether the period between funding and gifting results in the taxpayer bearing a “real economic risk.” When dealing with less volatile assets, the difficulty of proving “real economic risk” is still uncertain. For example, in Heckerman, there was another transaction with the underlying asset consisting of real estate. The period between funding of the LLC and gifting of the entity interests was approximately two weeks. Interestingly, the IRS did not dispute the use of valuation discounts for this transaction. This is noteworthy because under the Linton analysis, it would seem that if the IRS did dispute this transaction, a period of two weeks would not be sufficient for proving “real economic risk” and the valuation discounts would be disregarded for gift tax purposes. Thus, if dealing with non-volatile assets, one should proceed with caution when planning the delay between funding and gifting.